During the second half of the year, the financial markets continued to react to decreases in housing prices and the attendant issues in the banking system. Stocks experienced the first 4th Quarter losses since 2000. The previous trend had been for markets to appreciate during the last quarter of the year anticipating the influx of bonuses and retirement plan contributions. However, this year, the credit and economic concerns trumped typical end-of-the-year optimism.

In the financial and popular press, the US economy is frequently described as one “battered by a housing crisis.” A Google News search returned over 28,000 hits for the term “housing crisis.” The price for residential real estate across the country is decreasing and the inventory for unsold homes is increasing (currently at over 10 months), but there is no generalized crisis. Median housing prices have declined by about 3.3% from last year’s peak levels to $210,000 for all types of housing according to figures released by the National Association of Realtors. The year-over-year declines experienced this year represent the first decreases in almost 20 years!

Housing prices reached speculative levels which caused over-investment and the markets are now dealing with the aftermath. Wall Street investment banks and giant money-center banks such as Citi earned tremendous fees securitizing mortgages and then selling those debts in very complicated bond instruments. These same institutions are now stuck with these bonds which they are unable to value. So far the banks have taken between $80-100 billion in write-offs with every additional charge dragging the stock markets down further.

The Federal Reserve and the government have also been relatively ineffectual in addressing these problems. The Federal Reserve reduced its target rate from 5.25% to 4.25% over the past four months. However, lending rates as indicated by LIBOR have only decreased to 4.6% from 5.1% during the same period. The Federal Reserve’s policy to increase liquidity into the system is being counteracted by the banks’ fear that their counterparties might not be able to repay their debts. Therefore, the banks themselves continue to charge each other higher interest rates which reduces lending and retards economic activity.

One reason for these problems in the credit markets stems from the failure of the bankers’ models to work as expected. For example, every individual borrower has a credit score based on his or her historical ability to pay-off his debts. Given the primacy of home loans, it was widely assumed that individuals with good credit scores would pay their mortgages come good times or misfortune. However, these models did not take into consideration the fact that many homes purchased during the late stages of the bubble were bought for investment purposes and/or with almost no capital down. Borrowers who are often up-to-date on their credit card payments are walking away from their mortgages since they never put any money down. Since these borrowers had negative equity in their homes, their decisions to abandon these properties are economically rational.

Tighter credit has lead to slower economic activity. The Institute for Supply Management’s manufacturing index dropped to 47.7 in December which is the weakest number in 4.5 years and indicates a contracting manufacturing base. December’s unemployment rate also increased to 5% from 4.7% last month.

Even though these economic numbers are concerning, we still believe that creeping inflation is the greater threat to equity values. The most recent government numbers indicate that prices for consumer goods are 4.3% higher than they were last year. While the core figure excluding food and energy is only 2.3%, we believe the higher number is more accurate and that commodity prices are not poised to fall anytime soon. Energy prices increased 21% over last year and food prices appreciated by 4.8%. Similarly, inflation in the Euro Zone increased at a rate of 3.1% during November according to EuroStat. Finally, inflation in China is increasing at an even faster rate. During November prices surged at an annual rate of 6.9% and food prices increased at rate of over 18%. Energy prices increased a modest 5.5% since China subsidizes fuel costs to its population and industry.

Given our inflation concerns, we will continue to tilt the portfolios under our management to preserve capital in a rising price environment. Inflation is corrosive and undermines almost all asset classes except for cash and certain commodities which retain their value.

We believe that most of the bad news is priced in to stocks and stocks are still more attractive long term than fixed-income securities. Housing prices will stabilize at some point and real estate will become less of a drag on the overall economy. The credit markets will also normalize after the banks take appropriate write-downs. Even the simple passage of time gradually lessens problems in the bond markets since more and more loans are maturing daily and being replaced with simpler more transparent bonds. Volatility will most likely persist unabated until the markets receive positive signals regarding economic growth or receding inflation.